Could The USA Fall Into The Japan 18 Year Stagflation Trap?

There are now increasing opinions that the US may go the way of Japan - in having a prolonged stagflation. To refresh our memory, Japan's real estate and stock market bubble collapsed quite spectacularly sometime around 1990. The first couple of years saw a lot of wealth being erased from the real estate and stock portfolio. The following 16 odd years, even till today, basically saw Japan registering a period of stagflation or what some may refer to as the L-shaped recovery - i.e. you don't really recover. Japan made many policy mistakes (that the US should and could avoid):
a) it cut policy rates two years after the bust of its asset bubble while the US eased monetary policy aggressively after August 2007
b) it went into quantitative easing reversed ZIRP (zero interest rate policy) too slowly
c) it waited two years after the bursting of its bubbles to do a fiscal stimulus (and reversed it too early with a consumption tax) while the US did one – albeit a failed one – last year and is doing another large one now
d) it created a convoy system of zombie banks and corporate that were restructured too late while the US may become more aggressive in cleaning up the financial system
e) it had structural rigidities – like lifetime employment – that slowed down the adjustment while the US has a more flexible labor markets

If we were to look at the missteps by Japan, we might easily conclude that the US reacted much faster, swifter and the structural and employment adjustments were rapid as well. However, we must also acknowledge that Japan's bubble was in stocks and real estate - as bad as that sound, there were very little leverage or derivatives enlarging the bubble. The current credit implosion is largely driven by a leveraged credit, based on insufficient capital, propeled by new fangled derivatives. Thus in that light, the situation faced by the US was a lot worse than Japan.

Japan was in much better macro and financial shape than the US before and during its stagnation: high household and national savings and low leverage of the household sector, net foreign asset position that allowed it to finance its large fiscal deficit during the stagnation via domestic savings. The US instead has had near zero household savings and massive leverage for years, large current account deficits and is the largest net foreign debtor in the world. Thus any further fiscal stimulus by the US basically is further deficits on an already damaging deficit problem. The problems are in the US are magnified by the high debt levels on the personal level as well, and would eat immediately into consumption patterns. Whereas in Japan they still had truckloads of savings.

Fiscal policy has its limits when you are already the biggest net debtor and net borrower in the world and where you need to borrow this year $2 trillion net ($2.5 trillion gross) to finance your fiscal deficit ... and your currency is still backed by nothing. The US is taking an approach to bank recap and clean-up that looks more like Japan than the successful Swedish outright takeover/nationalization process. While the bad bank idea might work, it will require the US taxpayers to pony up another $2-$3 trillion to fund that bad bank. How many trillions of USD can you print before China and Russia turn around and say "wtf...".

The US and global economy are truly risking a near-depression if the policy reaction is not bold, aggressive, sustainable and credible. For almost every action that the Treasury or the government has proposed, there will be tons of criticisms, and that's beauty and beastly side of a true democracy. This credit crisis is not quite like any we have seen before as it involved an enormous amount of leverage, hence we have no textbook solutions to guide us. Hence, we can be assured that every single policy action, be it the TARP, the reworked and reworked stimulus plan, the bailouts, and now the bad bank idea ... will have a lot of detractors... and probably not many cheering the measures even if they agree (as no one is really sure they will work well).

We also have to remember that there are mainly two main schools of economic thought - though you could probably have tens of shools of economic thought on this - either you are a Keynesian or you are Gasparino (libertarian market purist). The latter being that mainly you think the markets should be allowed to correct itself, and bad companies should be allowed to fail, and shareholders should not be saved... or something to that effect. There are still many more who have opinions along those lines of thought which differ here and there, so you can understand why everyone is an asshole and an expert at the same time.

Back to the Japan trap, its government spending soared (after a couple of years following the correction) as a massive public works program covered the country with cement. Yet Japan also prevented the bust from performing its role of creative destruction. Businesses were reluctant to shed workers and renege on their lifetime employment guarantees. Japanese authorities encouraged banks to supply new credit to weak companies. This served to worsen the bad-debt problems within the banking system, which came to a head in the 1997 financial crisis. Academic research suggests that the increasing dominance of certain industries by so-called "zombie" firms tended to depress job creation and lower productivity. Product prices in zombie industries were low because of excess competition. Low prices and high wages reduced profits and discouraged new investment.

I was working for Nomura, the biggest Japanese securities firm then from 1988-1991, and I can say that Japan did one thing right: government spending increase. They did many things wrong which was what dragged the recession into a stagflation period for over ten years: they did not force bad banks to fail; the worst was allowing banks to not act on bad debts thus keeping technically insolvent businesses alive for years; the life-time employment culture caused many companies not to restructure; not allowing the banks to seek foreign investment to replenish their capital; not allowing foreign ownership of banks and most other companies which would have restructured many of them and given them much needed capital.

Hence to use the Japan experience to somehow link it to the futility of what the US government agencies are doing is flawed, very flawed. The bubble was deflated in stocks and property, stocks crashed because its a relatively open market with foreign participation, property died slowly as there were too many regulations preventing foreign ownership. I basically think that the US moved fast and aggressively, and industries are being restructured quickly, ... I don't like the bad bank idea but it will work best if you don't take the nationalisation route. The US will throw everything at the problems at hand. Its not much point to harp on how much money they will be flooding the system to do that. Yes, the USD is doomed for a long long depreciation. Its the lesser of two evils, throw more money at the problems... as not doing anything will be anarchy.

So, I do think that while the problems are huge, the US will be able to recover much faster and will not fall into the stagflation trap of Japan.

p/s photos: Megan Lai

Is Asia Doing Enough Stimulus?

Well, the US can afford the stimulus because it can print as much Treasuries that it wants as long as there are demand for it. Other countries don't have it so good. Other countries have to watch our balance sheet, our reserves, our foreign debt levels, etc... Its unfair, and the global economic paradigm will shift, albeit slowly, to require more accountability from the US, but until then, we have to play by the slanted rules. Asia have come up with its own economic stimulus, with Japan and China hogging the limelight, and both should have no problem financing the stimulus. What about other Asian countries?

So far, Asian countries are introducing over $600 bn in fiscal stimulus to raise govt spending on infrastructure and public services, cut taxes, offer subsidies and ease credit for households and firms incl. exporters and SMEs in order to cushion domestic demand, promote investment and curtail job losses amid export slowdown and global recession. Stimulus by most countries have been a small share of GDP, esp. in those running deficits. Therefore, stimulus will be largely insufficient to offset the shortfall in private demand during 2009.

Apart from stimulus spending, other risks to fiscal deficit may reduce the ability of govts to use counter-cyclical policies: High food and fuel subsidy burden (esp. in in Indonesia, Malaysia, India, Taiwan, Vietnam), slowing income and corporate tax revenues. Cut in import tariffs/excise duties (to reduce import prices of food, oil) are reducing revenues; scheduled elections in 2008-09 in India, Indonesia and political uncertainty in Malaysia is also raising populist spending.

India - Eased credit access for NBFCs, infrastructure, housing, SMEs, export firms in 2nd stimulus. 1st stimulus of $4bn incl. additional spending; value-added tax cut; export credit and elimination of duties; govt refund for sales taxes; tax-free bonds for infrastructure. Fiscal deficit may hit 8-9% of GDP in 2009.

China - $586 bn fiscal stimulus package is dominated by infrastructure spending but includes tax reform to support fixed investment, and social security investment, provide capital SMEs; has increased selected export rebates. But falling revenues post challenge. Furthermore some of the package is repackaging of older projects. Still, China's stimulus if enacted speedily, will cushion the slowdown from export demand somewhat. Dollar for dollar, the China's stimulus is greater in its effects than the $825 bn proposed by Obama.

Taiwan - speed up infrastructure and investment-promotion projects, distribute spending vouchers, loan guarantees for businesses. Budget deficit to be around 2% of GDP in 2008-09. One of the mildest stimulus packages - does the Taiwanese think they are so different from the rest?

Malaysia - RM7 bn stimulus to boost govt investment, spending on infrastructure, public services, incentives for firms. Govt planning for another RM7-10 bn package. Deficit estimate for 2009: 4.8% of GDP. Unlike other market watchers, I am not terribly concerned with the level of deficit funding as that is just one side of the story. I am comfortable with another RM7-10 bn package. Just stop lying to the people - our politicians need to grow up because the populace have. Its not like 30 years ago whereby you can control the media and say the right things and lull people into a false sense of security. The internet is the great equaliser with most taking their news and analysis from the web rather than mainstream media. We all know the global credit crisis is bad, what we want is a government that acknowledges the problem and deals with it. Nobody is blaming the government, we ride it out but we want honest people to us things as it is, and not whitewash them. Its a credibility issue.

Thailand - Announced 3 stimulus packages to alleviate the impact of inflation on poor and govt's waning popularity; Oct-08:10 billion baht injection into SET, accelerated disbursement of government expenditure; Aug-08: $1.3bn package to cut excise tax on fuel, subsidize transportation and electricity; Mar-08: Personal and corporate tax cuts, state-owned bank loans to small businesses and low-income earners. Will raise 2009 deficit to 3.5% of GDP

HK - higher fiscal spending incl. rent concession, Inflation relief package, electricity subsidies, cash grants; reduce diesel duty and fuel tax; projected $15 bn surplus for 2008-09 and may return $7bn to public (20% of total spending). Being the most open economy in the world, HK has the added cushion of being the services capital to mainland China. The flow on effects of China's stimulus will help HK somewhat.

Indonesia - 27.5 trillion IDR package in tax incentives and lower import duties for labor intensive exporting firms, lower diesel and electricity tariffs, spending on infrastructure and public services, create 3 mn jobs. Deficit forecast to rise to 2.5% of GDP in 2009 financed by multilateral loans. Hate to say this but Indonesia will be more harshly affected than most of its neighbours. It has to do with its balance sheet.

Singapore - S$20.5 bn in tax incentives and public works spending. Includes corporate tax cut, tax rebates for industrial/commercial properties, loss-making firms to retain local workers. Split risks of bank loans to firms; rebates for citizens, the poor and unemployed. deficit forecast for FY2009 of S$8.7 bn (3.5% of GDP) will be financed using S$4.9 bn of its forex reserves. The country which has put out the most aggressive stimulus and defence plan. The package is already more than 3x the size proposed by Malaysia. Singapore is more vulnerable owing to its open economy and property bubble there as well.

Vietnam - $1bn stimulus fund (to aid businesses) as part of the overall $6bn stimulus package to promote consumption and investment incl. construction projects, electricity plants, low-income housing; cut taxes on businesses. Deficit expected to rise to 7% in 2009. Vietnam was already in trouble prior to the global credit crisis. Will be a long hard slog for the country. Beware companies that still have huge committments in Vietnam.

p/s photo: Zhou Wei Tong